Theory and reality of stock market speculation

Share Shah

Efficient market theory believes that market players analyse historical and current present market price signals that are presumed to provide information about future events. This results in forming rational expectations as a basis for making maximising decisions. If players take actions based on these rational expectations, then markets are efficient in that the resulting stock prices operate in optimum position. Prof. Samuelson stipulated that rational expectations was necessary for developing economics as an empirical science. He surmised that the estimates of objective probabilities could be calculated from observed data provided from statistically reliable information. Thus the conditional probability function will govern future outcomes. This became a necessary foundation for efficient market theorists. If there are market fundamentals that are unchangeable in the sense they can not be changed by human action then these fundamentals determine the conditional probabilities of future outcomes.
   Then how will economists explain the existence of speculative activity on financial markets? One explanation of the existence of speculative activity depends on the fact those decisions involving outcomes that will occur in the future depends on the psychology of the market players. One obtains significantly different explanations regarding the effects of speculation and the efficiency of financial markets depending on whether one accepts or rejects the concept that economic is truly a science. That it is not a natural science is a fact.
   In efficient market theory, the players gather information about fundamentals to calculate statistically reliable probabilities regarding the future. Accordingly, the future is merely the statistical shadow of the past. If gathering this information is very costly, then there can be private incentives for each player to outpace others to calculate an actuarially reliable future. Thus beating the market "affects how the pie is divided, but does not affect the size of the pie", since the size is determined by fixed parameters, the so-called fundamentals. Future returns of the underlying assets are the inevitable outcomes pre-determined by current fundamentals and unalterable by human activity. Of course, this information will inevitably reveal itself in the long run in determining the secular trend of financial market prices. That is the future is immutably determined by fundamentals.
   Observed volatile asset price movements away from fundamentals determined values are attributed primarily to the existence of the speculators. They mistakenly believe they know how the stock market works and therefore do not have to acquire the correct information regarding future outcomes from the fundamentals. Those rational traders who feed on these foolish speculative traders ultimately return the market to its fundamental value. The mistaken belief of all speculators that they can do better than the market by ignoring the fundamentals explains the speculative volatility that we see in markets all over the world.
   But Keynes had argued that that speculation could have adverse effects on real economic outcomes. He suggested that public access to financial markets should be like access to casinos, "inaccessible and expensive". After the collapse of the Wall Street stock market in the 1929, Keynes suggested that the "introduction of a substantial government transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the dominance of speculation over enterprise in the United States".
   If financial markets are efficient and work on fundamentals which determins the future returns, then the irrational players who make persistent errors would either become extinct through a Darwinian economic process, or they may survive only by learning never to repeat the mistakes. But it must be recognised that after several centuries of significant volume of daily trades on financial markets, the daily trading volume have increased dramatically in the last two decades. Speculation continues to exist and even increase. But how can speculators continue to exist in an efficient market system where rational traders can feed off these fools? There is contradiction in logic between the implications of the efficient market hypothesis where those who keep on making errors are eradicated against the cause of volatile financial markets being attributed to the existence of fools. Therefore there has to be irrationality -a facts that it is ubiquitous, as continuous irrationality exists even among brightest persons.
   Keynes argued that at any point of time, the future is uncertain in the sense that the profit or a reliable mathematically based expectation of gain calculated in accordance with existing probabilities can not be obtained from any existing data. In 1937, he emphasised the difference between his "general theory" and classical orthodoxy. In the latter, "facts and expectations were assumed to be given in a definite form; and risks...were supposed to be capable of an exact actuarial computation. The calculus of probability...was supposed capable of reducing uncertainty to the same calculable state as that of certainty itself.... I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.... (a classical economist) has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be lead"
   In Keynes's analysis, therefore, even if fundamentals exist today and even if a data permits one to estimate current objective through probability distribution, such calculations do not form a reliable base for forecasting the future. In other words, current probabilities are not a reliable guide to the future. In Keynes's General Theory, financial markets cannot be presumed to be efficient as one can never expect whatever data exists today to provide a reliable guide to future outcomes. In such a world, the primary function of financial markets is to provide liquidity. This liquidity function involves the ability to buy and sell assets in an organised and orderly market in order to obtain the contractual settlement.
   Logical consistency for those claiming financial market efficiency requires the presumption that individual players can also plan their future spending on goods and services efficiently by buying and selling financial assets whose maturity date match the individual's life-cycle spending pattern stream vis-a-vis the individual's life-cycle income pattern stream. Sudden liquidity needs to meet uncertain, unpredictable future contractual obligations when they come due, or cases where issuers of financial assets can not meet their contractual obligation to pay interest or redeem at maturity date, have no role to play in efficient market theory.
   The only exception to this rule would be if the additional sample observations were being drawn from a different statistical universe, as for instance if a significant proportion of additional participants behave in a different manner than those observed in the original sample. Thus, if increased volume is a result of irrational participants suddenly entering the market previously dominated by rational beings, and then the market might exhibit what is called- irrational exuberance. In this case, provided the rational traders did not change their behaviour, one might expect a sudden short-run widening of variance (abnormal price fluctuation) despite the larger observed volume per day. In the longer-run, the larger the number of participants in an efficient market, the smaller the variance, since variance has the property of being inversely related to the size of a random unbiased sample. In the long run as an efficient market makes irrational traders extinct, the remaining sample will be unbiased. Only rational traders can survive. In other words, in the world of experience, conventional wisdom is that as long as it is expected that the psychology of the market is not changing there will be inertia in market valuations. It then follows that any policy that involves reducing if not eliminating the possibility of disruptive speculation in financial markets must involve building institutions that assure market participants that the correct market psychology is a belief in a persistent, stable trend in market prices over time.

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Holiday Desk

The Securities and Exchange Commission (SEC), the country's secondary market regulatory body, has approved the changes in its rules making initial public offering mandatory for the public limited companies (PLCs)once their paid-up capital reaches Tk 50 crore. The decision has been taken at a meeting of the SEC
   SEC Executive Director Farhad Ahmed informed newsmen after the meeting that 'the revised rules will be effective after gazette notification.'
   The PLCs in commercial operations for three years after reaching the paid-up capital level will have to issue IPOs within one year from the date of the gazette notification, he said.
   Under the existing rules, any PLC with a paid-up capital of Tk 50 crore has to go for an IPO only when the company wanted to further increase its capital base. The company could raise 30 per cent of the capital through an IPO.
   Besides, Farhad added, there was scope under the existing rules for the PLCs to avoid the capital market altogether.
   By streamlining the rules, the SEC has ensure raising the supply of securities in the country's capital market, the SEC chief said.
   PLCs, which have paid-up capitals of at least Tk 50 crore but remains out of commercial operations, have to issue IPOs in three years after the resumption of their commercial operations, he said.
   He said that the commission collects information on resumption of their commercial operations of the enterprises from the taxation authority.
   He said the SEC has also set a six-month time for mandatory conversion of private limited companies into public limited one if and when their paid-up capital reaches the Tk 40 crore. However, the private limited companies whose paid-up capital have already reached Tk 40 crore level will get a year to get converted into PLCs, he said.
   The SEC has also decided that from the next IPO, it would forfeit application money of the applicants whose beneficiary owner's accounts would be found invalid in the share allotment period.
   The SEC official said the commission found that number of invalid BO accounts in IPO allotment period was rising recently.
   Currently, the number of BO accounts, through which investors take part in trading, is around 14 lakh, but most of the accounts are used only to participate in the IPOs, said SEC officials.
   The regulatory body in its meeting also approved the Delta Brac Housing Finance Corporation Ltd's application for issuance zero coupon bonds of Tk 150 crore.
   'The zero coupon bonds of the company will be sold through private placements. It will enjoy a maturity period of five years,' the SEC chief said.

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